Merger Arbitrage Strategy In China Capital Market

Merger arbitrage usually refers to purchasing the stock shares in the target firm in an M&A deal when the market price is below the announced acquisition price. The shares are held through the completion of the merger or otherwise when the merger is broken off officially. The strategy seeks to profit from the premium that is offered above the current market price for the target company. In practice, merger arbitrage strategy can take on many forms and has been a common investment strategy in the developed capital markets. Comparatively, merger arbitrage is a more novel strategy in the Chinese stock market.The Chinese stock market is an emerging capital market, which M&A regulatory policies, securities dealing regulations, financial innovation, margin requirements and settlement requirements differ often from that of the developed markets. Additionally, a vast percentage of all listed shares are held by various government agencies and enterprises; thus most M&A deals are conducted through private arrangements instead of public tenders. Since the Chinese stock market is not considered a mature capital market, its level of governance and enforcement are far from ideal, which suggests that inside trading may have a significant impact on the observed merger arbitrage profitability in this market. It then becomes an interesting empirical research question whether the observed merger arbitrage profit is also observed in the Chinese market.This research paper examines the merger arbitrage strategy in the Chinese market. Specifically I examine two issues:(1) whether merger arbitrage profit exists in the Chinese market and (2) what are the appropriate merger arbitrage strategies for the Chinese market.I examine all public tender offers up through year end of 2008. I apply the event study methodology combined with the cumulative abnormal return methodology (CAR) and Calander Portfolio Investment methodology to measure merger arbitrage profit in the Chinese market. My finding shows that (1) holding the target stock shares for a fixed period generates a higher merger arbitrage profit than holding the shares through the completion (or termination) of the tenders; (2) purchasing the shares immediately on announcement date generates higher merger arbitrage profit than purchasing shares over several days; (3) purchasing shares in the target firm upon the initial announcement of the M&A generates a higher merger arbitrage profit than purchasing after the full tender disclosure is made available; and (4) with the appropriate strategy, merger arbitrage can be profitable in the Chinese market.From September 1993 through December 2008, there were 86 centralized bidding acquisitions in the Chinese market. This study discovers that (1) After the 5% purchase is announced, the excess return at the short-window period is statistic significant more than zero; (2) In regard to the excess return in the short-window period, the difference between the two, Strategic Investment and Value Investment, is not statistically significant; (3) Compared to the later 5% purchase announcement, the first 5% announcement will have a higher excess return in the short-window period. According to my study, the optimized merger-arbitrage strategy in the centralized bidding acquisition is to hold the target stocks for twenty-three days after the first 5% purchase announcement. This strategy will generate the largest excess return of 5.20%.From January 1st,2002 through December 31st 2008, there were 601 Agreed Acquisitions in the Chinese market.The study discovers that an 8 day holding period results in optimal abnormal profits; the cumulative excess return averages 2% over the holding period. However, it is important to point out that this strategy is exposed to market risk. So investors may suffer negative absolute return associated with the strategy in a declining market.The main innovative contributions of my research are:(1) Based on the China capital market's legal and economic background and from the view point of practical experience, I use empirical analyses to propose and measure the efficacy of the merger arbitrage strategies associated with the three distinct public tender M&As.(2) In combination with the China market's reality, I submit the optimal holding period concept for the agreed tender M&A. I use statistical techniques to estimate the optimal period. This provides a direction and tool for operating the merger arbitrage practice in the China market.My study supports the limited arbitrage theory that arbitrage activities cannot efficiently and effectively eliminate the arbitrage price difference in the China market. My study theoretically justifies the fact that merger arbitrage can be used as an investment strategy in the China capital market.